Thursday, 8 August 2013

Detroit – Just the beginning?

A city is driven into
bankruptcy by the same problems that plague the United States as a whole but will the
outcome be any different?

We have become all too accustomed to firms going bust recently
amid the economic doom and gloom but a city going bankrupt seems a little
strange. But that is what happened to
Detroit last month as years of decline culminated in the city admitting that it
was no longer able to pay its bills.
Having thrived along with the auto industry, Detroit was always doomed
to struggle as American car makers lost out to foreign rivals but its problems
are not that different from those facing the country as a whole – overgenerous
spending commitments from politicians focusing on the short term. Can the politicians in Washington do any
better in dodging a budgeting accident?

Detroit’s demise has come after it lost the industrial base
that was the foundation of the city – the manufacturing industry around Detroit
was decimated as overseas firms took a large chunk of the US auto market. The population of Detroit was close to two
million in 1950 but has since plunged to around a third of its peak as the
deteriorating job market prompted people to move elsewhere to find work. The exodus created a downward spiral with a
growing number of boarded up houses and deteriorating public services as tax
payers fled to more prosperous locations.

The sharp decline still left Detroit with a large number of
bills to pay, and along with having to maintain the infrastructure of a
shrinking city, there was also the pensions for its public sector workers. Its debts are estimated at $18.2 billion but
around half of this money is owed to its present and past workers in the form
of promises of retirement pay-outs. It
is common for government workers to be paid pensions which are a percentage of
their salary (referred to as defined benefit plans) which is different to the
private sector where workers must pay into their own pension pot from which
pensions are paid out (referred to as defined contribution plans).

Promises made by politicians have come back to haunt their
successors – offering up bigger pensions rather than higher wages as a means to
placate government workers with lower pay rates. Pledges made when times are good are
difficult to uphold when things turn bad especially since officials fail to put
away sufficient funds to cover future pension payments. The fixed sums offered to public sector
employees after retirement have become more of a burden with people living
longer and investments yielding a lower return after the global financial
crisis (which means that the initial level of funding of pension pots is
higher). It is like a massive scheme of offering
up IOUs with big pay-outs in a few decades but not bothering to put away much
money to settle up in the future.

Detroit was not the first city to go bankrupt (Stockton,
Mammoth Lakes and San Bernardino in California did in 2012) and it will not be
the last (even some of the largest firms in the United States such as General
Motors and most of the airline companies have been laid low by lavish pension
schemes), but more crucial are the similar problems faced by the federal
government in the United States. The US
government has committed to paying pensions and medical bills for the old and
poor which will gradually ramp up the pressure on the government budget as the
baby boomer generation heads into retirement and the number of workers per
pensioner falls (i.e. costs will rise as revenues fall but more slowly than in
the case of Detroit). Social spending on
these and other entitlements accounted for 56% of government spending or almost
14% of GDP in 2012 and increasing spending is threating to overwhelm the
government spending plans.

The approach of a fiscal disaster comes at a bad time - the
US government is already struggling to sort out a considerable budget deficit
equal to 7.0% of GDP in 2012. The timing
is made even worse when considering that the dominant global position of the
United States is under fire due to the rise of new powers such as China (for more on this, see A New Inconvenient Truth). Instead, politicians would rather squabble
than deal with the raft of problems facing the country with numerous other
areas such as taxation and immigration also crying out for reform. Even sensible adjustments to policy, such as
increasing the retirement age to account for people living longer, get vilified
with both the Democratic and Republican parties at each other’s throats. Elections do little to resolve the issues
with politicians happy to just target their own supporters (refer to Election with no winners for more detail). The country as a whole is being driven toward
the same destination as Detroit and politicians would rather play a game of
chicken amongst themselves than steer clear of trouble – watch out for
accidents in the road ahead.